Investment Function

Theory of Income and Employment

Kishor Bhanushali Faculty – Economics IBS - Ahmedabad

CLASSICAL ECONOMISTS 

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The classical economist held the view that, and economy based on laissez faire principles, is always in the state if equilibrium at full employment Free market mechanism ensures optimum allocation of resources Actual output equals potential output. There is neither underemployment nor overproduction Wherever there is a deviation from an equilibrium situation, the invisible hands of demand and supply come into operations and brings the economy back to equilibrium Role of money is only to facilitate transactions. It does not play any significant role in determination of output and employment. The level of output and employment are determined by the availability of real resources i.e. labour and capital

Say’s law of Market “Supply Creates its own

Demand” Barter Economy Monetary Economy No Unemployment Wage Cut Strategy

Keynes’ Theory Income, Effective Demand and Employment

Investment

Consumption

Income

MPC

Supply of Money

MEC

Rate of Interest

Liquidity Preference Supply Price Or Cost

Prospective Yield

Theories of Aggregate Consumption  Relationship between aggregate consumption

expenditure and the level of Income 2. Absolute Income Theory of Consumption 3. Relative Income Theory of Consumption 4. Permanent Income Theory of Consumption 5. Life- cycle Theory of Consumption

Keynesian Consumption Function (Absolute Income Theory)  Consumption function is relationship between

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disposable income (Y) and consumption expenditure (C) Consumption Function C = f (Y) Consumption expenditure is positive function of Income “men are disposed, as a rule and on average, to increase their consumption as their income increases, but not by as much as the increase in their income” C/ Y is Positive but less than unity

MARGINAL PROPENSITY TO CONSUME (MPC) MPC refers to the relationship between marginal income and marginal consumption  As income increases, people tends to consume a decreasing proportion of the marginal income  Keynesian theory of consumption produces a non-linear consumption function  MPC and APC C C = a + b Y 

C = f (Y)

Consumption Expenditure

0

Y Disposable Income

Saving Function  Relationship between Savings and

Income  S = f (Y) Y = C + S S = Y – C  S = Y – (a + b Y)  S = - a + (1 – b) Y

RELATIVE INCOME THEORY – (DUSENBERRY) A

household having a relatively lower income and living in community of higher incomes tend to spend a higher proportion of its income than the household with higher incomes.  Demonstration effect  The Rachet Effects in Consumption behaviour : when absolute income increases, absolute consumption increases. But when absolute income decreases, the household do not allow their consumption to fall in proportion to the fall in their incomes

PERMANENT INCOME HYPOTHESIS Milton Friedman  It is the permanent income and not the current income which decides the level of output.  Permanent income, defined broadly, is the mean of all the income anticipated in the long run  In the long run transitory income gains and losses are assumed to cancel out 

LIFE CYCLE THEORY OF CONSUMPTION Ando and Modiglini  Individual’s consumption in any time period depends on (i) resources available to the individual (ii) the rate of return on his capital and (iii) the age of the individual  A rational consumer plans consumption on the basis of all his resources and allocates his income to consumption over time so that he maximizes his total utility over his life time 

Investment  Investment in the theory of income and

employment means and addition to the nation’s physical stock of capital like building of new factories, new machinery, as well as addition to the stock of finished goods  Investment means net addition to the stock of capital over a period of time

Investment  Purchase and sale of securities  Gross and Net investments  Planned (ex-ante) and Actual (ex-post)

investments  Public and Private investments  Autonomous investments  Induced investments

Factors Affecting Investments  Marginal Efficiency of Capital  Rate of Interest  Excess capacity  Technological progress

Marginal Efficiency of Capital  Marginal Efficiency of Investment is the

highest expected rate of profit which is likely to be had by a marginal increase in the rate of investment  It is perspective yield and not actual yield  Marginal efficiency of capital is the rate at which prospective yields of an asset discounted so as to make it just equal to the supply price of or replacement cost of the asset  Cr = R1 + R2 + R3 + …………. Rn (1+r) (1+r)2 (1+r)3 (1+r)n

Diminishing Marginal Efficiency of Capital  The marginal efficiency of capital falls

as investment increases because (i)installation of larger machine leads to reduction in their perspective returns (ii)price of machine will go up as their demand increases  Marginal efficiency of investment is likely to be a curve falling from left to right

Y

Rate of Interest

Given marginal efficiency of capital, the investment will depend on the prevailing rate of interests

MEC O

X Investment